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The market considers a variety of inputs in pricing the value of
a floating currency. The dollar has more going for it than is
generally understood.

The conventional view looks at the domestic credit
bubble, the trillions in derivatives and the phantom assets
propping the whole mess up and concludes that the only way out is
to print the U.S. dollar into oblivion, i.e. create
enough dollars that the debts can be paid but in doing so,
depreciate the dollar's purchasing power to near-zero.
This process of extravagant creation of paper money is also
called hyper-inflation.
While it is compelling to see hyper-inflation as the only way out
in terms of the domestic credit/leverage bubble, the
dollar has an entirely different dynamic if we look at foreign
exchange (FX) and foreign trade.
Many analysts fixate on monetary policy as if it and the
relationship of gold to the dollar are the foundation of our
problems. These analysts often pinpoint the 1971 decision by
President Nixon to abandon the gold standard as the start of our
troubles. That decision certainly had a number of consequences,
but 80% the dollar's loss of purchasing power occurred before the
abandonment of dollar convertibility to gold.The depreciation from 1971 on looks rather modest on this
chart. Clearly, dropping the convertibility of the
dollar to gold did not change the overall depreciation dynamic
much; the dollar had been losing purchasing power since the turn
of the century.

Here is the dollar's purchasing power plotted by another source.
Note how the purchasing power fluctuated significantly in the
19th century. The emergence of the (privately owned) Federal
Reserve as the issuer of the dollar accelerated the dollar's
depreciation--a decline interrupted only by the deflationary
Great Depression.To understand the dollar's
primary role as a means of exchange for trade, let's start with
the relative size of the foreign exchange
market. The FX markets trade some $2 trillion a
day, far larger than either the credit or stock markets.Fiat currency is the ultimate phantom
asset. It is quite miraculous when you think about
it. We print some symbols and images on a piece of paper, and we
can exchange that intrinsically worthless paper for real goods
and materials: oil, electronics, vehicles, and so on. That magic
privilege is certainly worth maintaining.So why would anyone trade real tangible wealth (say, oil)
for specially printed paper? There are basically
three reasons:
1. They can use the paper to buy goods and services from other
nations. 2. They can buy bonds with the paper money that will
draw interest and be paid as promised. 3. When the money is
withdrawn to exchange for goods and services, it has retained the
vast majority of the purchasing power it held when
deposited.If we look at the charts above, we might wonder why
anyone would accept U.S. dollars (USD) as payment for real goods
when it so steadily loses purchasing power. The
answer can be found by re-reading the three conditions above: if
the USD draw interest, and that income is larger than the loss of
purchasing power, then the money will still retain its purchasing
power when withdrawn.
For instance, if the USD deposits draw 5% annual interest and the
USD loses 3% of purchasing power every year, the owner of the
dollar still earned a 2% positive return.There is another interesting feature of interest-bearing
bonds: as interest rates decline, the bond rises in
value. This sets up the delicious irony of the
Chinese whining about their $1 trillion in U.S. Treasury bonds
earning such low yields, while in fact their holdings have
greatly increased in value as interest rates have declined.But what underpins a fiat currency's purchasing
power? Ultimately, the value of any paper
(free-floating) currency is based on the issuer's ability to
enforce claims on reliably stable income streams and assets. Any nation that promises to pay interest on bonds
denominated in its currency must be able to enforce its claim on
the national income via taxation. If the national income is too
unreliable or unstable to support the claim, the international
community loses faith in the currency and it depreciates to
zero even if the currency isn't printed with
abandon. In other words, the
value of the currency as an international means of exchange is
not just a function of monetary policy or money
supply; the market "prices" a free-floating
currency on a number of factors, all related to the three above
points.We all understand gold is an asset. The key
to understanding Nixon's decision to break the international
convertibility of the dollar to gold was the transition of the
U.S. from a net exporter to a net importer.
In the 1960s, France famously demanded that the trade imbalance
between the U.S. and France be settled in gold: when the U.S. ran
a trade deficit with France, the "amount due" France had to be
paid in gold.
Once U.S. domestic oil production peaked and it became necessary
to import oil, the U.S. became a net importer in a deeply
structural sense. With the dollar convertible to gold, eventually
the exporting nations would have ended up with all the U.S.'s
gold, and that was not going to happen.
The solution was to float the dollar and trade paper money for
the oil.
(There is another fundamental reason why the U.S. became a net
importer not just of oil but of finished goods and raw materials,
and we'll look at that later.)But the magic of trading paper for oil could only be
maintained if the paper retained the vast majority of its
purchasing power over typical investment timeframes. In this, the U.S. held the immense
advantage of issuing the reserve currency, i.e. paper money
accepted globally for payment of debts. But this privilege was
not magic; the currency still had to reliably draw interest and
retain its purchasing power.
Ultimately, the USD retains its value based on the U.S.
government's claim to the nation's immense income stream, its
assets and its ability to attract international capital.We can understand the market's "pricing" of these
variables by asking: if we had to hold a currency
for trading purposes, i.e. to settle debts resulting from global
trade, and we needed to hold some of that currency for five
years, which currency would be most likely to retain its
purchasing power, based on the income stream, assets and capital
flows of the issuing nation?
This question illuminates the varied nature of assets. Yes, gold
and oil are assets; but so is enabling the free flow of
international trade, for example. We can ask the question
somewhat differently: is it within the power of the
currency's issuer to mandate its purchasing power five years
hence? How much of the market's "pricing" is
outside the control of the issuer?Take the euro as an example. Does anyone
seriously believe the European Central Bank (ECB) retains
sufficient global control over the euro's valuation to mandate
its value five years hence? The currency's viability is in
question even now, never mind in five years.
Clearly, much of the market's pricing of the euro's value is
outside the control of the euro's issuers; whether they admit it
or not is irrelevant.In a similar fashion, China dares not let the renminbi
float lest the market "price in" the instabilities implicit in
China's economy and trade. If we were able to tote
up true capital flows out of China, it is entirely possible that
capital flows have reversed, and more capital is flowing out of
China into the U.S. than is flowing from the U.S. to China.
If we don't understand capital flows are assets, then we
understand neither capital flows nor what constitutes an
asset.How about Japan? The yen is currently
viewed as a "safe haven" due to the great stability and wealth of
Japan. But two decades of massive deficit spending and debt
accumulation are finally putting pressure on Japan, Inc., and
those willing to bet the yen will retain its current purchasing
power for five more years are taking on an extraordinary amount
of risk that has yet to be priced into the yen.
Once again, the question boils down to how much of the yen's
purchasing power is in the hands of its issuers. For 20 years,
Japan's domestic purchases of its own debt kept the global market
at bay. As domestic savings rates dry up and the ageing Baby
Boomers start cashing in their bonds and drawing pensions, the
system may finally be exposed to global market "pricing" of risk.
That exposure could destabilize the yen's position as "safe
haven."
Whatever your calculus, it is self-evident that of all the
issuers of major currencies, the U.S. retains the most control
over the elements the market uses to "price" the risk that the
dollar's value as a means of exchange and store of value is
unsettled.There is yet another way to understand the market's
valuation of the dollar, and any other floating
currency. If you are holding a large amount of a
nation's currency, the ultimate value of that currency can be
discovered by what you can buy in the issuer's nation
with its paper money. If restrictions on foreign
ownership crimp what you can buy, the currency's value reflects
that. If there is relatively little of value to buy, or the risks
of ownership are high, then once again the market will mark down
the "price" of that currency.
Despite its myriad problems and challenges, the U.S. allows a
fairly broad range of foreign ownership of land, corporations,
etc. If you have surplus dollars, you can buy property or an oil
well in the U.S. It may not produce much oil, but the output can
be sold domestically and its value is relatively easy to
calculate. The U.S. economy is vast and there's a wide variety of
things and assets to buy with your dollars. In other words, there
is a vast market that will accept your dollars in exchange for
tangible goods and assets.
I have made the case technically for over a year that the U.S.
dollar has reversed its long downtrend and is now in a structural
advance. If we examine the multiple dynamics of FX, foreign trade
and the market's pricing of currencies, we can discern a strong
fundamental case for this advance as well. There is no magic in
free-floating currencies, there is only the market discovering
the price of numerous inputs, only some of which are easily
quantifiable.This was drawn from Musings Report 30. The Musings are sent
weekly to subscribers and major contributors ($50 or more
annually). Here are some samples of the Musings.Resistance, Revolution,
Liberation: A Model for Positive Change (print
$25)(Kindle eBook
$9.95)Read the Introduction (2,600 words) and
Chapter One (7,600 words) for free. We are like
passengers on the Titanic ten minutes after its fatal encounter
with the iceberg: though our financial system seems unsinkable,
its reliance on debt and financialization has already doomed
it.We cannot know when the Central State and financial system
will destabilize, we only know they will destabilize. We cannot
know which of the State’s fast-rising debts and obligations will
be renounced; we only know they will be renounced in one fashion
or another.
The process of the unsustainable collapsing and a new, more
sustainable model emerging is called revolution.Rather
than being powerless, we hold the fundamental building blocks of
power. We need neither permission nor political change to
liberate ourselves. A powerless individual becomes powerful when
he renounces the lies and complicity that enable the doomed
Status Quo’s dominance.